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The iShares Mortgage Real Estate Capped ETF (BATS:REM) is an ETF containing various US mortgage REITs, which in turn own mortgage assets. REM is pretty heavily skewed towards residential mortgages, which is alright since it at least gets it out of the way of issues in other parts of real estate, namely offices, where there are some issues with a few of the REITs contained in REM. There is some duration risk as mortgages are long-term maturities, but focusing more on the credit matter that we began to concern ourselves with for REM in our last coverage. We are taking a more general view and starting to worry about the maturity walls and the potential impact that they might have on the credit situation among borrowers.
REM Breakdown
REM contains mortgage REITs listed on the US markets. Most are pretty heavily indexed to residential. But there are some like Blackstone Mortgage Trust, Inc. (BXMT) that have exposure to office loans, and those are quite seriously troubled by higher finance costs and of course the relevant staying power of WFH. Office real estate remains an area of persistent issues and is a place where you could really impair your capital.
As far as residential mortgages, the fact of the matter is that unemployment figures are still strong, and there aren’t many jobless claims. There have been some concerns about GDP growth coming in below expectations, but all in all, there isn’t a major worry about the credit conditions in the mortgage market for the time being.
There has been some increase in delinquencies.
Mortgage Delinquency Rate (Mortgage Bankers Association)
These increases are relatively local, as they are lower than a year ago but also quite clearly coming up after the rate hikes. Although, much for the same reasons that inflation has been stubborn, quite a lot of fixed rate mortgages and a safely levered US public have meant a lot of the pressure of higher headline rates has been mitigated.
Bottom Line
The performance of mortgages as an asset class can be quite linked to the performance of the economy in terms of unemployment rate which for the time being remains low, hence the high inflation if you use Phillips Curve logic.
We have a concern which is the maturity walls in 2024 and 2025 which could change the paradigm. It is our belief that the maturity walls could make the difference for Fed policy transmitting, and that higher corporate debt rates will start impacting restructuring, bankruptcy and other metrics that will make its way quickly to raising unemployment. We have seen a dearth of restructuring mandates for the last four years, and this eventually has to change given headline rates. We think the change will articulate around the maturity walls.
Maturity Wall effect on average interest in the US (VTS)
In our SPY (SPY) prediction piece a couple of months ago we made the case that given the yield curve (which has translated upwards since we put together the chart above), the rate of fixed debt in corporate America, the average rate on that debt and the size of the 2024 maturity wall, growth in average interest would be around 17%. Then in 2025 another big wall comes, and interest expenses would grow again.
A 17% increase in interest expenses, which is a substantial rise, could weigh heavily on the market, perhaps not the SPY exactly but especially the leveraged industrial and cyclical middle market in America, struggle to maintain net profitability. We think that this will trigger a more forceful transmission of Fed policy into factors that affect the economy more severely, namely unemployment rates. This should in turn start to impact mortgage values as credit concerns rise.
The global financial crisis isn’t the best reference since it concerned the market in which mortgages were securitised, and therefore massively impacted demand for mortgages as securities, but the value of mortgages can clearly collapse when you have substantial growth in the unemployment rate, which there was at that time (more than 70% decline then). We want to see what happens to maturity walls first before we start playing with these high duration instruments so that later in 2024 we can start judging.